As a small business owner, Chapter 7 bankruptcy may be an attractive option when you are overloaded with debt. While it will mean the end of your business, the court will clear you of your obligation to pay back certain debts entirely as opposed to a Chapter 11 business bankruptcy, in which the court reorganizes your debt, giving first priority to tax obligations. However,if you happen to owe taxes to government agencies, it's important to understand what taxes can and cannot be eliminated in Chapter 7.

Tax Type

In a Chapter 7 bankruptcy, the only types of federal taxes that can be discharged are personal income taxes. So if you own an LLC, partnership or corporation, the income tax debts of those entities cannot be discharged. If your business owes payroll taxes, the IRS may "pierce the corporate veil" without ever going to court and hold you personally liable for a portion of the payroll tax debt from the business. This is called a Trust Fund Recovery Penalty and is the most common example of a personal tax assessment that cannot be discharged in a Chapter 7 bankruptcy. Unpaid sales taxes assessed by the state will not be discharged either. The bankruptcy code does permit the discharge of certain real estate taxes, as long as the property taxes were assessed prior to your filing bankruptcy. In addition, the property taxes must be at least a year old and payable without additional penalties in order to be included.

Income Tax Discharge

In order to discharge personal income tax liabilities in a Chapter 7 bankruptcy, you must have actually filed the tax return and had the tax assessed. This probably goes without saying, but the bankruptcy court will not allow you to discharge income tax debts or penalties that were incurred as a result of tax evasion or fraud. If you filed a fraudulent tax return, were found to be using illegal tax shelters or filed a return with a fraudulent Social Security Number, the resulting tax liability is ineligible for discharge in bankruptcy.

Timing

The most important part of determining whether or not personal income tax debts can be discharged in a Chapter 7 has to do with three very important timing rules. These are the three-year rule, the two-year rule and the 240-day rule. In order to include any particular tax year in your bankruptcy, you must wait until at least three years after the tax return was due. For example, you couldn't include 2006 taxes in your bankruptcy unless you had waited until at least April 17th, 2010, to file your bankruptcy application, because that is three years after your 2006 tax return was originally due. The two-year rule means that you must wait until at least two years after filing the tax return for a particular year in order to include it. This means that you can include tax years for which you filed late, but you need to wait out the two years. Lastly, since the IRS often takes several months to process tax returns, especially if you filed late, and therefore does not bill you for the tax debt right away, you must wait at least 240 days after the IRS assesses a tax against you before you can include it in your bankruptcy.

Tax Liens

If you personally owe the IRS more than $5,000 for tax years prior to 2012, for any tax type, it most likely filed a lien against you. For 2012 and later, this threshold was increased to $10,000. This lien gives the government a claim to all property that you own, including your retirement accounts, cash in the bank and any business property if you are a sole proprietorship. So, while the bankruptcy may remove your obligation to pay the tax liability, and IRS Collections will not come after you, you must, unfortunately, still satisfy any liens against your assets in order to sell them.

About the Author

Jassen Bowman is an IRS-licensed enrolled agent who specializes in IRS collections representation, small business tax law and international tax treaties. He has also served as a licensed real estate broker and investor. Bowman holds a Bachelor of Science in nuclear engineering technology.